Saturday, January 3, 2015

More Cash and Zero Bound

In my last post I started thinking about how options other than currency enforce a zero bound. Imagine there is no more currency, and the Fed tries to impose -5% interest rates. You put in a dollar, you get out 95 cents. What other ways are there to guarantee that if you put in a dollar you get back a dollar? (In my last post, I also pointed out that in each case rules or laws could be changed, but that the magintude of the required changes was pretty big.)From Kenneth Garbade and Jamie McAndrews in a nice Liberty Street Economics blog post

Certified check. Go to the bank, tell the bank to write you a $10,000 certified check. Put it in your sock drawer. (More: "Certified checks, which are liabilities of the certifying banks rather than individual depositors, might become a popular means of payment, as well as an attractive store of value, because they can be made payable to order and can be endorsed to subsequent payees.")

Or, inspired by that:

Don't cash checks. Every 90 days, call up, say you lost the check, ask them to reissue it.

Clumsy. But as Ken and Jamie point out, it's very easy for a company to get started that does this, and offer fixed-value accounts to clients, beating the -5% at banks. Or, even in today's super-regulated environment, maybe banks could figure out to do this. After all, the Medici figured out in the 1400s to write offsetting bills of exchange to synthesize interest.

So, the project will mean changing the rules and laws governing checks, going back hundreds of years.

Currently money market funds promise fixed value, and pay positive interest. They are not set up to charge negative interest, or to allow capital losses. Maybe they should -- I've argued for floating NAV -- but they don't. The Fed kept the 0.25% rate on reserves precisely so banks and money market funds didn't have to reinvent themselves in ways that allow capital losses or negative rates.

Miles Kimball has also been writing in favor of negative nominal rates and thinking about the zero bound. One post is here.

16 comments:

I think that you are showing how difficult it is to influence portfolio decisions simply by removing one financial instrument (cash / guaranteed deposits) because there are many close substitutes available. On the other hand, financial decisions are highly influenced by norms and conventions. People get their paychecks deposited in guaranteed dollar accounts, and pay their bills through those accounts, without much reflection about the possible alternatives.

Historically the federal government made an important contribution by establishing a uniform currency. In our time, it needs to follow up with a higher-yielding instrument for payment purposes that could be multiplied and resold by banks, safely. It would be more risky, with a possibility of negative returns. If many people subscribed to these high-yielding current accounts, the massive portfolio shift would do more to help the macroeconomy than regulations that merely inspire creative efforts to evade them, and promote the careers of people who manage to accumulate regulatory knowledge.

"Historically the federal government made an important contribution by establishing a uniform currency. In our time, it needs to follow up with a higher-yielding instrument for payment purposes that could be multiplied and resold by banks, safely."

I disagree that the higher yielding instrument needs to be acceptable for payment purposes. It would be enough for the instrument to be tradable in a marketplace for currency or be convertible to currency through the issuing agent (federal government).

The question becomes, should the central bank be involved in a market for such instruments? If the instrument is to be risky, then the central bank should not be in the market for such instruments either as a buyer or seller.

Frank, mainly what I want is for the new unit to be the basis of a new current account offering. People could receive their pay through the new instrument and pay their bills using it. That will reduce the demand for dollar accounts, which can only be safe if they are segregated and backed by US Treasuries. We need a banking unit such that typical bank assets are adequate backing for it.

But you are right that the role of the Central Bank is seriously in question with proposals like this, or Prof. Cochrane's advocacy of floating-rate Treasury securities as money, or his automatic system for inflation-targeting using TIPS spreads. On the Central Bank dealing in risky securities, personally I like Perry Mehrling's formulation of Central Bank as dealer of last-resort. We don't really need it involved in the market during normal times, but we would still need a backstop during crises.

"Frank, mainly what I want is for the new unit to be the basis of a new current account offering. People could receive their pay through the new instrument and pay their bills using it."

In other words you want a dual currency system? Why? If people want risk assets, it should be entirely their choice to buy them - not pushed onto them by an employer who insists on paying wages in them or a vendor who insists on receiving them in payment for goods. Why not a 3 or 4 or 10 currency system or just go straight to an electronic barter system and skip the whole notion of a common currency?

"We don't really need it involved in the market during normal times, but we would still need a backstop during crises."

No, we don't need the central bank as a backstop during "crises". Otherwise, you will always face "crises" of one sort or another - promoting a backstop to be employed only during a crisis ensures that a crisis will be created to engage the backstop. The central bank is given by Congress lender of last resort authority which is more than enough. Congress (in their good sense) has limited the central bank to buying / selling securities that have zero default risk - that should not be changed under any circumstances.

If a company manufacturers more goods that it can sell, and that excess production pushes a company into bankruptcy, should the central bank let the bankruptcy happen or buy up the excess production? That type of bankruptcy would result in millions of lost jobs and constitute a fairly significant "crisis".

Why not 3, 4 or 10 currencies? Because a long time ago James Tobin showed that the public really needs only two assets, one of which is risk-free debt. Prof. Cochrane wants to turn that first one into an electronic form of interest-paying money. I think it would be great to turn Tobin's other asset into another form of electronic money as well. Would it be bad if people started writing long-term contracts in terms of the second unit rather than the first (i.e. dollars)?

If you are serious about downgrading the role of the Fed, I think it would be good. Remember the argument Kevin Sheedy provided the Market Monetarists for their policy rule: it is needed because people write long-term contracts in dollars, and need help with their balance sheets after economic shocks. If we start writing contracts using optimal units, then there are fewer objections to adoption of Cochrane's automatic inflation-targeting system, and retirement of Market Monetarism.

And why limit this to what the public "really needs" or a dead economist thinks the public "really needs". If two currencies are better than one, then why not 3, 4, 10, or 100?

"Would it be bad if people started writing long-term contracts in terms of the second unit rather than the first (i.e. dollars)?"

Would it be bad if I wrote a long term contract with you in a third unit and you wrote a long term contract with Joe in a fourth unit and Joe wrote a long term contract with Phil in a fifth unit ad infinitum?

If you want to know more about the point made by Tobin there are many pages online describing his Separation Theorem. And any change in the monetary system requires collective action. Some people are proposing a tax on dollars to break through the zero lower-bound. I am proposing a second monetary unit in order to make monetary policy unnecessary.

"Under mean-variance analysis, it can be shown that every minimum-variance portfolio given a particular expected return (that is, every efficient portfolio) can be formed as a combination of any two efficient portfolios."

The article goes on to describe how such a portfolio can be constructed either with or without a risk free asset, and so I am not sure why risk free debt is required.

The measure of risk used in this article is a mean variance framework - how far do realized returns deviate from expected return.

"And any change in the monetary system requires collective action."Agreed. Why wouldn't collective action move a two currency system back to a single currency system?

Maybe I misunderstood you - do you want a second currency to operate side by side with the dollar or do you want to replace the dollar entirely?

Also, there are an infinite number of minimum variance portfolios - why not an infinite number of currencies to correspond to every conceivable portfolio?

Risk-free debt is required as a numeraire. Now remember that we are commenting on a post on "cash and the lower-bound". No one wants to eliminate the dollar as numeraire, but the dollar also exists in cash form, and that is causing a problem for monetary policy. I would solve this by adding another asset for every member of the monetary union. So for the Euro zone, I would indeed add a bunch of new forms of deposit - one for each banking system. I think it would be more effective than taxing cash. Let the best proposal carry the day!

"Under mean-variance analysis, it can be shown that every minimum-variance portfolio given a particular expected return (that is, every efficient portfolio) can be formed as a combination of any two efficient portfolios."

Meaning a risk free return can be synthesized from two efficient portfolios without risk free debt.

"So for the Euro zone, I would indeed add a bunch of new forms of deposit - one for each banking system."

The Euro zone is made up of distinct sovereign governments (France, Germany, Italy, etc.), not distinct banking systems. If you are advocating the return of a central bank for each Euro member, then the Euro would likely be extinguished (no central fiscal authority would exist to back Euros).

I've been reading the descriptions of negative interest rates, which in effect reduce the money supply (unless we also get to borrow money at negative rates). It seems to me that negative interest rates are equivalent to deflation as prices would decrease as money is taken out of the system. They would also appear to result in all the "evils" of deflation, such as loans retaining the same nominal value, essentially increasing the principal of loans relative to the money to pay them off.

That is a pretty good understanding. One thing to be aware of is the possibility of negative market rates. Bonds sold by the federal government at auction will have a positive interest rate (who would reasonably lend at a negative rate even to the federal government?).

However, the central bank (through open market operations) can buy that debt from the market. It remains to be seen whether the central bank can pay a premium for that debt to reduce it's yield to maturity below 0%. There are government limitations on what the central bank can purchase in the open market, but to my knowledge there are no legal limitations on the price the central bank can offer.

Let's try to protect Keynes' good name from the keynesians, who emerged from the woodwork only after he was safely dead: The zero bound for Keynes was something to be guarded against in the context of the monetary policy of his time and place. He never doubted that a monetary policy a outrance would work. It's just that he didn't think, or rather, knew, that his Bank of England would never embark on such a (correct) course. It might not be wrong to say he undertook a magnificent exercise in the second-best.

Cf the Federal Reserve in the wake of the financial crisis in our time: While it surely didn't appreciate all the ins and outs of financial markets, it did undertake a monetary policy a outrance, and the patient did far better than had he been subjected to the bloodletting of the 1930's.

Please forgive me for this perhaps pseudo-historical trivia, but it is being forgotten, and does not deserve such.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!